In praise of error

Baruch came back from a lovely long holiday to find he may have been totally wrong in his last post about Apple. Embarrassingly, fist-bitingly wrong, in a 100%, black-is-white sort of way. He thought the new iPhone wouldn’t sell, as the new features on the new one weren’t, according to him, worth the upgrade. Wronggg!! Apparently old iPhone 3G is selling so badly that Apple is transferring all production to the 3G S, and taking the old iPhone off exclusivity in certain markets. Business has never been so good. It is early days, to be sure, and perhaps the situation will reverse itself. But right now the conclusions of my last post, however cogently argued, simply don’t hold water. In fact, the opposite seems to be happening.

This is good opportunity to ponder on what it means to be wrong in an investment context.

Now for many people, being this wrong would be a bad thing, more than anything because it looks embarrassing. If Baruch was some sort of pundit or commentator, or a full time blogger, he might be tempted to brush it under the rug and pretend it never happened. Or cavil it away (I never meant that . . ), or launch an ad hominem attack on the source (in this case a well-connected analyst at a big bank, via his salesman; trust me, these people are used to ad hominem ). Certainly some in Baruch’s audience will be disappointed, and possibly not take him seriously again. “Cancel my subscription, sir!” Competing commentators will rub their hands. In a media context there are no prizes for error.

However in dealing with the real world, and in an investment context, being wrong is often the best thing that can happen to you, providing a) you recognise it, and b) you have left yourself in a position to do something about it. First off you can cut your losses; bravo! You have been falsified!

When a position doesn’t work or is falsified (say, your invasion of Iraq isn’t going well), if you remember that you were just positing a thesis and knew you were probably wrong, you can flip it without a second thought. Many hold on when they shouldn’t, ashamed to admit error, desperately seizing on any item of good news, racking their brains to find reasons why the bad news isn’t actually bad, while all the while forgetting they should just sell. This is a recipe for losing lots and lots of money. I used to make this mistake a lot and, very rarely, sometimes still do. Of course, you let your winners run.

More important, though, is to make sure ahead of time that you’re in a position where you CAN sell, and before you get in, to set out the conditions under which you’ll know you’ve been falsified. This is the oft-mentioned “stop-loss” level. For your stop to work without losing too much money you’ll need to be in something liquid, and this means, most probably, not using a lot of leverage. There’s nothing worse than knowing about its impending doom, but owning so much of a position that selling would bring about the very collapse in price you would be trying to avoid by selling. Ask the guys at LTCM.

But the most important thing about being wrong is this: you now have very clear, new information for a new series of potentially much more accurate logical deductions. Eliminating potential outcomes equals more conviction in the ones that remain; you can place more money on this bet, so the payoff may be much bigger than what you lost in the first stage of being wrong. Having thought through the erroneous trade in the first place, you may be analytically one step ahead of those who are only just starting out. You may be able to react much faster than they to the new piece of information and its implications, and maybe enter your new position before the price has time to react. Your post-error trade may end up making you more money than the original trade would have if it had actually worked!

This is what experienced traders mean when they talk about “knowing how to take a loss”. For a concrete example, why not take the one at hand? Knowing now that Apple is cleaning up in the smartphone market with new product likely means, firstly, that AAPL is going to print better gross margins when it reports (this actually happened I think). Cover any AAPL short, go long. It’s extra bad for all the players who have been hurt by Apple since iPhone 3G came out. Nokia and Motorola spring to mind. But you may also guess that the smartphone market may not be very price sensitive, and cares about phone specs and software. Find players with well-specced alternatives. Think that PALM maybe has a shot. Be suspicious about the budget end of the spectrum; low end smartphones (Nokia’s supposed 2010 strategy) may be as attractive to discerning punters as discount sushi.

More money is lost through shame and the compounding of error that accompanies it, I think, than through merely being wrong. Our emotional need to appear smart in front of our bosses, peers and colleagues is a major handicap to proper investing cognition. If during working hours I could temporarily disconnect the areas of my brain where emotion resides, I am sure I would make more money. A further conclusion is this: put yourself in a position where you can make errors. Don’t worry too much about whether to put on a trade; if you have thought it through a bit and have a price to stop it at, do it. If you are still worried, do it in small size. But do it. We learn our best lessons through mistakes. As a great man of Baruch’s acquaintance put it:

In life, and in every form of endeavour, there is the possibility of mischance, error and futility. But merely to avoid the attempt because certainty is impossible to achieve is to be inhibited by an immaculateness so overwhelming that nothing will ever be accomplished.

Professionally I do indeed feel deformed sometimes. However I think many people would like to have their emotions disconnected at work. It would make things so much easier. I mean work is sort of supposed to be slightly unpleasant. I am lucky, I actually like my job and were I suddenly rich and never had to work again I would possibly do something like it for fun anyway.

But for most everyone else it’s called “work” and not “fun” for a reason.

Forgive me polluting your post with a bitter anecdotal nugget. I recently spurned an iPhone in favour of a low-end Nokia smartphone (the N79, should you be interested), since I was unwilling to sign a 2-year AT&T contract at the current iPhone spec and with thoughts of emigration playing through my mind. One can find an unlocked N79 at nokia.com for about $309. The catch is that it’s on backorder, and if you can work out how the hell something can be on backorder when buying direct from the manufacturer you’re a smarter man than me. I believe that they will overnight it to you if you will pay them $439 for it. Which suggests some kind of crude discriminatory pricing regime to me. Now this might work in every other market than the US, where Nokia is a genuinely desirable brand. Where, as Nokia’s defenders will point out, 3MP cameras are considered children’s instruments and a symbian operating system is the developer’s platform of choice. But in the US this kind of torpor is known as, ahem phoning it in. Presumably Mr. Jobs’ reality distortion field has Nokia paralysed.

Echoing Kypala’s comment, you should be careful what you wish for. You wrote: “If during working hours I could temporarily disconnect the areas of my brain where emotion resides, I am sure I would make more money.”

Neuroscientists have done day-trading studies of people with a type of brain damage that “turns off” emotions, but keeps “rational” thought active. While the emotionless traders did do better than the “normal” control group at a significant level, the researchers also looked at the emotionless traders’ personal finances. Their rates of personal bankruptcy were sky-high and they fell victim to investment scams far more frequently. The researchers concluded that emotional intelligence (what I would call the “primitive lizard brain” of flight risk from danger) was vital for holistic economic survival on and off the trading desk.

But it seems to be the case that this “error” was due to a profound anti AAPL bias that had nothing to do with its performance or management or returns or success or failure.

The tone of all your AAPL related post were screaming: “I hate those guys, they do not conform, they do not fit my model of how a properly capitalistic company should be run, and whatever success they achieve must be only be short lived, and only due to fads, not sound business practices”

You might have to learn recognising a white swan when you see one! :-)

a) your views are too intriguing and pragmatic to be ignored; it’s a crime you are only a very part time blogger.
b) facts do not always register with the herd mentality, and when herd guess against you, it’s all about patience & risk management. (you seem to excel in both)
c) consumers will continue de- leveraging, as the result consumers might become rather price than fashion conscious. That in turn spells trouble for the Apple business model, unless they will reinvent it and focus on capitalizing on contents rather than hardware.
d) “Be a ball” was the best advise I ve seen in a long while, right back at you…

Verec, you are right, of course. Yet I make no secret of my AAPL bias. Spinoza would not have approved of them at all. It’s not just my tone, you know.

Comrade, you embarrass me with praise. I am sorry I do not write more often. I have been away on holiday for lots of the past month, and the rest of it has been filled with results season. This is very tiring.

I hope to write more as the occasion and inspiration arises!

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